Despite the shenanigans at WorldCom, America's telecoms industry could soon be on the mend

FINANCIAL fraud is supposed to be a sophisticated business. That is why boards of directors, regulators and auditors find it so hard to stop. But the $3.8 billion accounting fiddle that WorldCom, a once-high-flying telecoms firm, owned up to this week lacks any of the impenetrable dealings that masked the worsening finances at Enron. WorldCom, it turns out, did not bother with the likes of off-balance-sheet partnerships to hide its problems. It simply made the numbers up.

The rumours had been growing. But nobody had any inkling of the mess that John Sidgmore, WorldCom's new boss, revealed on June 25th. Following the departure in April of Bernie Ebbers, WorldCom's founder, an internal audit discovered an “irregularity” in the way the company had been booking capital expenses. A subsequent investigation found that $3.8 billion-worth of costs had been wrongly classified as capital expenses over a five-quarter period from the start of 2001. KPMG, which replaced the firm's longstanding external auditors, Andersen (yes, them), in May, is investigating further. Unlike costs, capital expenses are written off against profits over time, so the error boosted reported cashflow and profits. WorldCom reported a profit of $1.4 billion last year, and $130m for the first quarter of 2002. These numbers were, in fact, fictitious.

Companies have been misclassifying costs for years. In 1971 in Britain, Rolls-Royce went under after fooling itself that costs related to the development of a new jet engine were in reality capital expenditure. But the problems at Rolls-Royce looked like old-fashioned British incompetence. The motives at WorldCom seem altogether more modern.

So far, everybody is blaming Scott Sullivan, WorldCom's chief financial officer until he was sacked on June 25th. “Our senior management team is shocked by these discoveries,” said Mr Sidgmore. Nevertheless, on June 26th the Securities and Exchange Commission (SEC), which had been investigating the company's accounting, charged WorldCom with fraud.

One person the SEC will want to talk to is Mr Ebbers, who was under pressure to raise WorldCom's sagging share price. Mr Ebbers owes WorldCom over $400m, which he borrowed to bet on WorldCom shares. These loans are secured on Mr Ebbers's personal assets, including a yacht-sales company, a soyabean farm, and nearly 27m WorldCom shares. The entire board had a strong motive to keep up the share price. Between them, the 12 directors and executives named in the company's latest proxy statement, filed in April, own nearly 50m WorldCom shares. Even the outside directors are big owners: Max Bobbitt, a telecoms consultant who chairs WorldCom's audit committee, has nearly half a million shares.

Mr Sidgmore will now have to rethink his tactics. The company had been hoping to negotiate a $5 billion bank loan, in part to refinance a $2.65 billion loan on which it is now in default (because its accounts no longer comply with GAAP standards). These negotiations now look doomed. That leaves liquidation or restructuring as the main options. Nancy Kaplan of Adventis, a telecoms consultancy, thinks that any attempt to restructure WorldCom will fail. The company is good at selling data and other telecoms services to its corporate customers. This is a business with real margins and growth prospects. But it has lots of weak businesses as well, including its declining consumer long-distance unit and its failed mobile-telecoms arm. This makes it harder to shrink.

The more likely outcome, says Ms Kaplan, is that WorldCom's competitors will pick off its assets at bargain prices. These include thousands of miles of “backbone” fibre-optic cable, which runs between cities, together with WorldCom's efforts to upgrade the “last mile” underneath cities so that businesses can connect to this broadband network. Both have problems. The capacity glut in backbone fibre persists. And the patchwork of networks that run beneath the world's big cities lacks scale and is plagued with technical problems. Top of the list of buyers ought to be AT&T, WorldCom's only serious competitor in the business-services market. In the present environment, however, it is hard to see how AT&T is going to raise the money to buy anything.

It is these sorts of “doom loops”, says Bill Bane of Mercer, a consultancy, that prevent investors from seeing the bottom for the telecoms industry. Shareholders greeted this week's news by dumping telecoms shares more enthusiastically than ever. Two things could change that. One, says Mr Bane, is if the fibre-optic capacity glut turns into a supply shortage. Although Enron made markets in it, fibre-optic backbone is not really a fungible commodity. Customers who want to send data from New York to London cannot use the pipe that goes to Washington, DC. That leaves any pair of destinations vulnerable to a capacity shortage.

Also forgotten in the current industry rout, says Mr Bane, is that demand for fibre-optic cable is growing by 75-150% every year. Mr Bane foresees a scenario in the not-too-distant future in which big companies find that their delicate, just-in-time, global electronic supply chains seize up. That will cost them huge sums of money, prompting them to buy or lease their own private, global fibre-optic networks from the telecoms companies. This, of course, would tighten the supply squeeze. Prices would soar. If it were still around, WorldCom might then once again be worth hundreds of billions of dollars.

The other possible outcome is that WorldCom, AT&T and other telecoms companies that serve business customers are absorbed into the Baby Bells, the local telephone operators that the regulators hived off from AT&T in 1984. These bureaucratic, sleepy near-monopolies have found favour with investors recently. America's regulators and antitrust officials have, until now, viewed their expansion into other markets with caution. After its turbulent experiments with deregulation, however, America craves stability from its all-too-excitable telecoms companies. The Baby Bells could certainly supply that.